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Memo to Apple: Here's Your Next Big Thing

Apple's been plagued by slowing top-line growth and eroding margins, here's how they can solve both problems.

Apple(NASDAQ:AAPL) has the opportunity to build share and boost margins by creating a new smartphone market -- the super-premium segment -- a strategy that aligns with the company's history of developing aspirational products, and takes advantage of Apple's enviable pricing power.

Remember what the iPad Mini did to marginsThe release of Android Honeycomb 3.0 in early 2011 marked the point when Google's (NASDAQ:GOOG)(NASDAQ:GOOGL) operating system began competing with the iPad in terms of features and functionality, as Honeycomb 3.0 was the first Android operating system optimized for tablets. However, Apple held an advantage in manufacturing costs for 10-inch tablets, and Android 10-inch tablets couldn't compete based on price. The Motorola Zoom, the first Honeycomb 3.0 tablet, cost $600 for a 16 GB model, $100 more than a comparable iPad. The answer for Android tablets came in the form of the Samsung Galaxy Plus 7.0, a high-quality 7-inch tablet with a $399 price point. Users liked the 7-inch form factor of the tablet and the $100 dollar savings versus the 10-inch iPad.

Facing increasing demand for smaller tablets, Apple launched the iPad Mini in February 2012. According to NPD Research, Apple expected the iPad Mini would account for 40% of total iPad sales. However, the Mini proved to be far more successful than Apple anticipated; Gartner estimated that the Mini accounted for 60% of iPad unit sales in the first quarter of 2013.Unfortunately for Apple, the iPad Mini's margins were significantly lower than the rest of the company's products, putting higher-than-expected pressure on the company's margins.The graph below shows the dramatic impact of the iPad Mini on Apple's margins and stock price.

The iPhone 5c and 5s provide a clue to Apple's new strategyThe launch of the iPhone 5c last year showed that Apple was no longer willing to take margin risks on lower-priced mobile products. The 5c maintained the iPhone's customary high margins, despite its lower price point.

Ironically, Apple's sales projections for the 5c and 5s were off. Tim Cook later admitted the 5c unit sales were lower than expected, while the 5s sold more units than Apple forecasted.

Apple's lesson? When given a clear choice between features, (the 5s has Touch ID, the 5c doesn't) and materials (iPhone 5s has a metal casing, iPhone 5c is plastic), the majority of Apple customers opt to pay the higher price for the premium product.

Using screen size and screen material to create a "super-premium" phoneLarge screen phones now account for 22% of smartphone purchases and have a clear advantage to users looking for a more "tablet like" experience. Sapphire glass, in which Apple is investing heavily, offers a significant improvement to smartphone screen durability. The introduction of a large-screen iPhone with sapphire glass provides an opportunity for Apple to offer customers a clear choice regarding features (large screen) and materials (sapphire glass), which could support a new super-premium iPhone segment.

Profit share versus market shareMarket share can be a poor measure of business health. While the majority of smartphone growth is in the low end of the market, the profits are in the high end. According to Raymond James, the iPhone now accounts for 87% of smartphone profits. Given the results of 5s and 5c sales, the creation a super-premium smartphone segment is a logical move for Apple.

Foolish takeawaySales results of the 5c and 5s underscore the willingness of Apple customers to pay a premium for a smartphone, provided there is clear differentiation in material and functionality. The release of a larger-screen iPhone with sapphire glass provides the opportunity to create a higher-priced segment for the iPhone, increasing revenue, margins, and profit share for the company.

Author

Market analyst, economist, stat geek, and comedy writer. My goal at The Fool? Tell the story behind the numbers. I've developed competitive analysis for Fortune 500 companies, managed an econometric model of US price and wage indices, and written comedy for syndicated radio programs. BA economics/computer science, University of Maryland. MBA Georgia Institute of Technology. Follow me at: @bshammy